10 Myths About Financial Derivatives

by Thomas F. Siems

Thomas F. Siems is a senior economist and policy adviser
at the Federal Reserve Bank of Dallas. The views expressed here are those
of the author and do not necessarily reflect the position of the Federal
Reserve Bank of Dallas or the Federal Reserve System.

Executive Summary

In our fast-changing financial services industry, coercive regulations
intended to restrict banks' activities will be unable to keep up with
financial innovation. As the lines of demarcation between various types of
financial service providers continues to blur, the bureaucratic leviathan
responsible for reforming banking regulation must face the fact that fears
about derivatives have proved unfounded. New regulations are unnecessary.
Indeed, access to risk-management instruments should not be feared but,
with caution, embraced to help firms manage the vicissitudes of the
market.

In this paper 10 common misconceptions about financial derivatives are
explored. Believing just one or two of the myths could lead one to
advocate tighter legislation and regulatory measures designed to restrict
derivative activities and market participants. A careful review of the
risks and rewards derivatives offer, however, suggests that regulatory and
legislative restrictions are not the answer. To blame organizational
failures solely on derivatives is to miss the point. A better answer lies
in greater reliance on market forces to control derivative-related risk
taking.

Financial derivatives have changed the face of finance by creating new
ways to understand, measure, and manage risks. Ultimately, financial
derivatives should be considered part of any firm's risk-management
strategy to ensure that value-enhancing investment opportunities are
pursued. The freedom to manage risk effectively must not be taken away.

Introduction

Remember the bankruptcy of Orange County, California, and the Barings
Bank due to poor investments in financial derivatives? At that time many
policymakers feared more collapsed banks, counties, and countries. Those
fears proved unfounded; prudent use, not government regulation, of
derivatives headed off further problems. Now, however, the Financial
Accounting Standards Board, the Federal Reserve, and the Securities and
Exchange Commission are debating the merits of new rules for derivatives.
But before adopting regulations, policymakers need to separate myths about
those financial instruments from reality.

The tremendous growth of the financial derivatives market and reports
of major losses associated with derivative products have resulted in a
great deal of confusion about those complex instruments. Are derivatives a
cancerous growth that is slowly but surely destroying global financial
markets? Are people who use derivative products irresponsible because they
use financial derivatives as part of their overall risk-management
strategy? Are financial derivatives the source of the next U.S. financial
fiasco--a bubble on the verge of exploding?

Those who oppose financial derivatives fear a financial disaster of
tremendous proportions--a disaster that could paralyze the world's
financial markets and force governments to intervene to restore stability
and prevent massive economic collapse, all at taxpayers' expense. Critics
believe that derivatives create risks that are uncontrollable and not well
understood. [1]
Some critics liken derivatives to gene splicing: potentially useful, but
certainly very dangerous, especially if used by a neophyte or a madman
without proper safeguards.

In this paper 10 myths, or common misconceptions, about financial
derivatives are explored. Financial derivatives have changed the face of
finance by creating new ways to understand, measure, and manage financial
risks. Ultimately, derivatives offer organizations the opportunity to
break financial risks into smaller components and then to buy and sell
those components to best meet specific risk-management objectives.
Moreover, under a market-oriented philosophy, derivatives allow for the
free trading of individual risk components, thereby improving market
efficiency. Using financial derivatives should be considered a part of any
business's risk-management strategy to ensure that value-enhancing
investment opportunities can be pursued.

Financial derivatives are not new; they have been around for years. A
description of the first known options contract can be found in
Aristotle's writings. He tells the story of Thales, a poor philosopher
from Miletus who developed a "financial device, which involves a principle
of universal application." [2]
People reproved Thales, saying that his lack of wealth was proof that
philosophy was a useless occupation and of no practical value. But Thales
knew what he was doing and made plans to prove to others his wisdom and
intellect.

Thales had great skill in forecasting and predicted that the olive
harvest would be exceptionally good the next autumn. Confident in his
prediction, he made agreements with area olive-press owners to deposit
what little money he had with them to guarantee him exclusive use of their
olive presses when the harvest was ready. Thales successfully negotiated
low prices because the harvest was in the future and no one knew whether
the harvest would be plentiful or pathetic and because the olive-press
owners were willing to hedge against the possibility of a poor yield.

Aristotle's story about Thales ends as one might guess: "When the
harvest-time came, and many [presses] were wanted all at once and of a
sudden, he let them out at any rate which he pleased, and made a quantity
of money. Thus he showed the world that philosophers can easily be rich if
they like, but that their ambition is of another sort." [3]
So Thales exercised the first known options contracts some 2,500 years
ago. He was not obliged to exercise the options. If the olive harvest had
not been good, Thales could have let the option contracts expire unused
and limited his loss to the original price paid for the options. But as it
turned out, a bumper crop came in, so Thales exercised the options and
sold his claims on the olive presses at a high profit.

Options are just one type of derivative instrument. Derivatives, as
their name implies, are contracts that are based on or derived from some
underlying asset, reference rate, or index. Most common financial
derivatives, described later, can be classified as one, or a combination,
of four types: swaps, forwards, futures, and options that are based on
interest rates or currencies.

Most financial derivatives traded today are the "plain vanilla"
variety--the simplest form of a financial instrument. But variants on the
basic structures have given way to more sophisticated and complex
financial derivatives that are much more difficult to measure, manage, and
understand. For those instruments, the measurement and control of risks
can be far more complicated, creating the increased possibility of
unforeseen losses.

Wall Street's "rocket scientists" are continually creating new,
complex, sophisticated financial derivative products. However, those
products are all built on a foundation of the four basic types of
derivatives. Most of the newest innovations are designed to hedge complex
risks in an effort to reduce future uncertainties and manage risks more
effectively. But the newest innovations require a firm understanding of
the tradeoff of risks and rewards. To that end, derivatives users should
establish a guiding set of principles to provide a framework for
effectively managing and controlling financial derivative activities.
Those principles should focus on the role of senior management, valuation
and market risk management, credit risk measurement and management,
enforceability, operating systems and controls, and accounting and
disclosure of risk-management positions. [4]

Put another way, this myth is that "derivatives" is a fancy name for
gambling. Has speculative trading of derivative products fueled the rapid
growth in their use? Are derivatives used only to speculate on the
direction of interest rates or currency exchange rates? Of course not.
Indeed, the explosive use of financial derivative products in recent years
was brought about by three primary forces: more volatile markets,
deregulation, and new technologies.

The turning point seems to have occurred in the early 1970s with the
breakdown of the fixed-rate international currency exchange regime, which
was established at the 1944 conference at Bretton Woods and maintained by
the International Monetary Fund. Since then currencies have floated
freely. Accompanying that development was the gradual removal of
government-established interest-rate ceilings when Regulation Q
interest-rate restrictions were phased out. Not long afterward came
inflationary oil-price shocks and wild interest-rate fluctuations. In sum,
financial markets were more volatile than at any time since the Great
Depression.

Banks and other financial intermediaries responded to the new
environment by developing financial risk-management products designed to
better control risk. The first were simple foreign-exchange forwards that
obligated one counterparty to buy, and the other to sell, a fixed amount
of currency at an agreed date in the future. By entering into a
foreign-exchange forward contract, customers could offset the risk that
large movements in foreign-exchange rates would destroy the economic
viability of their overseas projects. Thus, derivatives were originally
intended to beused to effectively hedge certain risks; and, in fact, that
was the key that unlocked their explosive development.

Beginning in the early 1980s, a host of new competitors accompanied the
deregulation of financial markets, and the arrival of powerful but
inexpensive personal computers ushered in new ways to analyze information
and break down risk into component parts. To serve customers better,
financial intermediaries offered an ever-increasing number of novel
products designed to more effectively manage and control financial risks.
New technologies quickened the pace of innovation and provided banks with
superior methods for tracking and simulating their own derivatives
portfolios.

From the simple forward agreements, financial futures contracts were
developed. Futures are similar to forwards, except that futures are
standardized by exchange clearinghouses, which facilitates anonymous
trading in a more competitive and liquid market. In addition, futures
contracts are marked to market daily, which greatly decreases counterparty
risk--the risk that the other party to the transaction will be unable to
meet its obligations on the maturity date.

Around 1980 the first swap contracts were developed. A swap is another
forward-based derivative that obligates two counterparties to exchange a
series of cash flows at specified settlement dates in the future. Swaps
are entered into through private negotiations to meet each firm's specific
risk-management objectives. There are two principal types of swaps:
interest-rate swaps and currency swaps.

Today interest-rate swaps account for the majority of banks' swap
activity, and the fixed-for-floating-rate swap is the most common
interest-rate swap. In such a swap, one party agrees to make fixed-rate
interest payments in return for floating-rate interest payments from the
counterparty, with the interest-rate payment calculations based on a
hypothetical amount of principal called the notional amount.

The financial derivatives market's worth is regularly reported as more
than $20 trillion. That estimate dwarfs not only bank capital but also the
nation's $7 trillion annual gross domestic product. Those often-quoted
figures are notional amounts. For derivatives, notional principal is the
amount on which interest and other payments are based. Notional principal
typically does not change hands; it is simply a quantity used to calculate
payments.

While notional principal is the most commonly used volume measure in
derivatives markets, it is not an accurate measure of credit exposure. A
useful proxy for the actual exposure of derivative instruments is
replacement-cost credit exposure. That exposure is the cost of replacing
the contract at current market values should the counterparty default
before the settlement date.

For the 10 largest derivatives players among U.S. bank holding
companies, derivative credit exposure averages 15 percent of total assets.
The average exposure is 49 percent of assets for those banks' loan
portfolios. In other words, if those 10 banks lost 100 percent on their
loans, the loss would be more than three times greater than it would be if
they had to replace all of their derivative contracts.

Derivatives also help to improve market efficiencies because risks can
be isolated and sold to those who are willing to accept them at the least
cost. Using derivatives breaks risk into pieces that can be managed
independently. Corporations can keep the risks they are most comfortable
managing and transfer those they do not want to other companies that are
more willing to accept them. From a market-oriented perspective,
derivatives offer the free trading of financial risks.

The viability of financial derivatives rests on the principle of
comparative advantage--that is, the relative cost of holding specific
risks. Whenever comparative advantages exist, trade can benefit all
parties involved. And financial derivatives allow for the free trading of
individual risk components.

Myth Number 4: Only Large Multinational
Corporations andLarge Banks Have a Purpose for Using
Derivatives

Very large organizations are the biggest users of derivative
instruments. However, firms of all sizes can benefit from using them. For
example, consider a small regional bank (SRB) with total assets of $5
million (Figure 1). [5]
The SRB has a loan portfolio composed primarily of fixed-rate mortgages, a
portfolio of government securities, and interest-bearing deposits that are
often repriced. Two illustrations of how SRBs can use derivatives to hedge
risks follow.

First, rising interest rates will negatively affect prices in the SRB's
$1 million securities portfolio. But by selling short a $1 million
Treasury-bond futures contract, the SRB can effectively hedge against that
interest-rate risk and smooth its earnings stream in a volatile market. If
interest rates went higher, the SRB would be hurt by a drop in value of
its securities portfolio, but that loss would be offset by a gain from its
derivative contract. Similarly, if interest rates fell, the bank would
gain from the increase in value of its securities portfolio but would
record a loss from its derivative contract. By entering into derivatives
contracts, the SRB can lock in a guaranteed rate of return on its
securities portfolio and not be as concerned about interest-rate
volatility (Figure 2).

The second illustration involves a swap contract. As in the first
illustration, rising interest rates will harm the SRB because it receives
fixed cash flows on its loan portfolio and must pay variable cash flows
for its deposits. Once again, the SRB can hedge against interest-rate risk
by entering into a swap contract with a dealer to pay fixed and receive
floating payments.

Figure 1Sample Balance Sheet of a Small
Regional Bank

Assets

Liabilities

Loans

$3 million

Deposits

Securities

$1 million

- Interest-bearing

$3 million

Cash and premises

$1 million

- Noninterest-bearing

$1 million

Equity

$1 million

Total assets

$5 million

Total liabilities and equity

$5 million

Figure 2Effect of Interest Rates on Securities
Earnings of a Small Regional Bank

Figure 3Effect of Interest Rates on Net
Interest Margin of a Small Regional Bank

Rates Drop300 bps

No Changein Rates

Rates Rise300 bps

Asset Yield (Loans)

7.00%

7.00%

7.00%

Liability Yield (Deposits)

-1.00%

-4.00%

-7.00%

Net Margin (w/o Swap)

6.00%

3.00%

0.00%

Fixed Swap Outflow

-4.50%

-4.50%

-4.50%

Floating Swap Inflow

0.50%

3.50%

6.50%

Net Swap Flow

-4.00%

-1.00%

2.00%

Net Margin (w/Swap)

2.00%

2.00%

2.00%

Say the SRB currently receives a 7 percent fixed rate from its loan
portfolio and pays a variable rate for its deposits that approximates the
three-month T-bill rate. The top portion of Figure 3 shows the SRB's net
interest margin under three scenarios, all of which assume that the T-bill
rate is currently at 4 percent: (1) rates falling 300 basis points, (2)
rates unchanged, and (3) rates rising 300 basis points. [6]
The SRB's net interest margin would decline with rising rates and increase
with falling rates.

To hedge that interest-rate risk, the SRB can negotiate with a swaps
dealer to pay 4.5 percent fixed interest in exchange for T-bill minus 0.5
percent (Figure 4). The net swap flow is shown in Figure 3 under the same
three scenarios. In this case, the value of the swap increases with rising
rates because the SRB receives floating-rate cash flows and pays fixed
rates.

As shown on the bottom of Figure 3, the swap provides an effective
hedge against interest-rate risk. With the swap, the bank has a guaranteed
200-basis-point spread, no matter what happens to interest rates. Without
the swap, the SRB could get badly burned by rising interest rates.

Figure 4Effect of Interest-Rate Swap on a
Small Regional Bank

The economic benefits of derivatives are not dependent on the size of
the institution trading them. The decision about whether to use
derivatives should be driven, not by the company's size, but by its
strategic objectives. The role of any risk-management strategy should be
to ensure that the necessary funds are available to pursue value-enhancing
investment opportunities. [7]
However, it is important that all users of derivatives, regardless of
size, understand how their contracts are structured, the unique price and
risk characteristics of those instruments, and how they will perform under
stressful and volatile economic conditions. A prudent risk-management
strategy that conforms to corporate goals and is complete with market
simulations and stress tests is the most crucial prerequisite for using
financial derivative products.

Financial derivatives are important tools that can help organizations
to meet their specific risk-management objectives. As is the case with all
tools, it is important that the user understand the tool's intended
function and that the necessary safety precautions be taken before the
tool is put to use.

Builders use power saws when they construct houses. And just as a power
saw is a useful tool in building a house--increasing the builder's
efficiency and effectiveness--so financial derivatives can be useful tools
in helping corporations and banks to be more efficient and effective in
meeting their risk-management objectives. But power saws can be dangerous
when not used correctly or when used blindly. If users are not careful,
they can seriously injure themselves or ruin the project. Likewise, when
financial derivatives are used improperly or without a plan, they can
inflict pain by causing serious losses or propelling the organization in
the wrong direction so that it is ill prepared for the future.

When used properly, financial derivatives can help organizations to
meet their risk-management objectives so that funds are available for
making worthwhile investments. Again, a firm's decision to use derivatives
should be driven by a risk-management strategy that is based on broader
corporate objectives.

The most basic questions about a firm's risk-management strategy should
be addressed: Which risks should be hedged and which should remain
unhedged? What kinds of derivative instruments and trading strategies are
most appropriate? How will those instruments perform if there is a large
increase or decrease in interest rates? How will those instruments perform
if there are wild fluctuations in exchange rates?

Without a clearly defined risk-management strategy, use of financial
derivatives can be dangerous. It can threaten the accomplishment of a
firm's long-range objectives and result in unsafe and unsound practices
that could lead to the organization's insolvency. But when used wisely,
financial derivatives can increase shareholder value by providing a means
to better control a firm's risk exposures and cash flows.

Clearly, derivatives are here to stay. We are well on our way to truly
global financial markets that will continue to develop new financial
innovations to improve risk-management practices. Financial derivatives
are not the latest risk-management fad; they are important tools for
helping organizations to better manage their risk exposures.

Myth Number 6: Derivatives Take Money Out of
Productive Processes and Never Put Anything
Back

Financial derivatives, by reducing uncertainties, make it possible for
corporations to initiate productive activities that might not otherwise be
pursued. For example, an Italian company may want to build a manufacturing
facility in the United States but is concerned about the project's overall
cost because of exchange-rate volatility between the lira and the dollar.
To ensure that the company will have the necessary cash available when it
is needed for investment, the Italian manufacturer should devise a prudent
risk-management strategy that is in harmony with its broader corporate
objective of building a manufacturing facility in the United States. As
part of that strategy, the Italian firm should use financial derivatives
to hedge against foreign-exchange risk. Derivatives used as a hedge can
improve the management of cash flows at the individual firm level.

To ensure that productive activities are pursued, corporate finance and
treasury groups should transform their operations from mundane bean
counting to activist financial risk management. They should integrate a
clear set of risk-management goals and objectives into the organization's
overall corporate strategy. The ultimate goal is to ensure that the
organization has the necessary funds at its disposal to pursue investments
that maximize shareholder value. Used properly, financial derivatives can
help corporations to reduce uncertainties and promote more productive
activities.

Myth Number 7: Only Risk-Seeking Organizations
Should Use Derivatives

Financial derivatives can be used in two ways: to hedge against
unwanted risks or to speculate by taking a position in
anticipation of a market movement. The olive-press owners, by locking in a
guaranteed return no matter how good or bad the harvest, hedged against
the risk that the next season's olive harvest might not be plentiful.
Thales speculated that the next season's olive harvest would be
exceptionally good and therefore paid an up-front premium in anticipation
of that event.

Similarly, organizations today can use financial derivatives to
actively seek out specific risks and speculate on the direction of
interest-rate or exchange-rate movements, or they can use derivatives to
hedge against unwanted risks. Hence, it is not true that only risk-seeking
institutions use derivatives. Indeed, organizations should use derivatives
as part of their overall risk-management strategy for keeping those risks
that they are comfortable managing and selling those that they do not want
to others who are more willing to accept them. Even conservatively managed
institutions can use derivatives to improve their cash-flow management to
ensure that the necessary funds are available to meet broader corporate
objectives. One could argue that organizations that refuse to use
financial derivatives are at greater risk than are those that use them.

When using financial derivatives, however, organizations should be
careful to use only those instruments that they understand and that fit
best with their corporate risk-management philosophy. It may be prudent to
stay away from the more exotic instruments, unless the risk/reward
tradeoffs are clearly understood by the firm's senior management and its
independent risk-management review team. Exotic contracts should not be
used unless there is some obvious reason for doing so.

Myth Number 8: The Risks Associated with
Financial Derivatives Are New and Unknown

The kinds of risks associated with derivatives are no different from
those associated with traditional financial instruments, although they can
be far more complex. There are credit risks, operating risks, market
risks, and so on.

Risks from derivatives originate with the customer. With few
exceptions, the risks are man-made, that is, they do not readily appear in
nature. For example, when a new homeowner negotiates with a lender to
borrow a sum of money, the customer creates risks by the type of mortgage
he chooses--risks to himself and the lending company. Financial
derivatives allow the lending institution to break up those risks and
distribute them around the financial system via secondary markets. Thus,
many risks associated with derivatives are actually created by the
dealers' customers or by their customers' customers. Those risks have been
inherent in our nation's financial system since its inception.

Banks and other financial intermediaries should view themselves as risk
managers--blending their knowledge of global financial markets with their
clients' needs to help their clients anticipate change and have the
flexibility to pursue opportunities that maximize their success. Banking
is inherently a risky business. Risk permeates much of what banks do. And,
for banks to survive, they must be able to understand, measure, and manage
financial risks effectively.

The types of risks faced by corporations today have not changed;
rather, they are more complex and interrelated. The increased complexity
and volatility of the financial markets have paved the way for the growth
of numerous financial innovations that can enhance returns relative to
risk. But a thorough understanding of the new financial-engineering tools
and their proper integration into a firm's overall risk-management
strategy and corporate philosophy can help turn volatility into
profitability.

Risk management is not about the elimination of risk; it is about the
management of risk: selectively choosing those risks an organization is
comfortable with and minimizing those that it does not want. Financial
derivatives serve a useful purpose in fulfilling risk-management
objectives. Through derivatives, risks from traditional instruments can be
efficiently unbundled and managed independently. Used correctly,
derivatives can save costs and increase returns.

Financial derivative participants can be divided into two groups:
end-users and dealers. As end-users, banks use derivatives to take
positions as part of their proprietary trading or for hedging as part of
their asset/liability management. As dealers, banks use derivatives by
quoting bids and offers and committing capital to satisfy customers' needs
for managing risk.

In the developmental years of financial derivatives, dealers, for the
most part, acted as brokers, finding counterparties with offsetting
requirements. Then dealers began to offer themselves as counterparties to
intermediate customer requirements. Once a position was taken, a dealer
immediately either matched it by entering into an opposing transaction or
"warehoused" it--temporarily using the futures market to hedge unwanted
risks--until a match could be found.

Today dealers manage portfolios of derivatives and oversee the net, or
residual, risk of their overall position. That development has changed the
focus of risk management from individual transactions to portfolio
exposures and has substantially improved dealers' ability to accommodate a
broad spectrum of customer transactions. Because most active derivatives
players today trade on portfolio exposures, it appears that financial
derivatives do not wind markets together any more tightly than do loans.
Derivatives players do not match every trade with an offsetting trade;
instead, they continually manage the residual risk of the portfolio. If a
counterparty defaults on a swap, the defaulted party does not turn around
and default on some other counterparty that offset the original
transaction. Instead, a derivatives default is very similar to a loan
default. That is why it is important that derivatives players perform with
due diligence in determining the financial strength and default risks of
potential counterparties.

For banking supervisors in the United States, probably the most
important question today is, What could go wrong to engender systemic
risk--the danger that a failure at a single bank could cause a domino
effect, precipitating a banking crisis? Because financial derivatives
allow different risk components to be isolated and passed around the
financial system, those who are willing and able to bear each risk
component at the least cost will become the risk holders. That clearly
reduces the overall cost of risk bearing and enhances economic efficiency.

Furthermore, a major shock that would jolt financial markets in the
absence of derivatives would also affect financial markets in which the
use of derivatives was widespread. But because the holders of various
risks would be different, the impact would be different and presumably not
as great because the holders of the risks should be better able to absorb
potential losses.

Myth Number 10: Because of the Risks
Associated with Derivatives, Banking Regulators Should Ban Their Use by
Any Institution Covered by Federal Deposit Insurance

The problem is not derivatives but the perverse incentives banks have
under the current system of federal deposit guarantees. Deposit insurance
and other deposit reforms were first introduced to address some of the
instabilities associated with systemic risk. Through federally guaranteed
deposit insurance, the U.S. government attempted to avoid, by increasing
depositor confidence, the experience of deposit runs that characterized
banking crises before the 1930s.

The current deposit guarantee structure has, indeed, reduced the
probability of large-scale bank panics, but it has also created some new
problems. Deposit insurance effectively eliminates the discipline provided
by the market mechanism that encourages banks to maintain appropriate
capital levels and restrict unnecessary risk taking. Therefore, banks may
wish to pursue higher risk strategies because depositors have a diminished
incentive to monitor banks. Further, federal deposit insurance may
actually encourage banks to use derivatives as speculative instruments to
pursue higher risk strategies, instead of to hedge, or as dealers.

Since federal deposit insurance discourages market discipline,
regulators have been put in the position of monitoring banks to ensure
that they are managed in a safe and sound manner. Given the present system
of federal deposit guarantees, regulatory proposals involving financial
derivatives should focus on market-oriented reforms as opposed to laws
that might eliminate the economic risk-management benefits of derivatives.
[8]

To that end, banking regulators should emphasize more disclosure of
derivatives positions in financial statements and be certain that
institutions trading huge derivatives portfolios have adequate capital. In
addition, because derivatives could have implications for the stability of
the financial system, it is important that users maintain sound
risk-management practices.

Regulators have issued guidelines that banks with substantial trading
or derivatives activity should follow. Those guidelines include

active board and senior management oversight of trading activities;

establishment of an internal risk-management audit function that is
independent of the trading function;

thorough and timely audits to identify internal control weaknesses;
and

It is the responsibility of a bank's senior management to ensure that
risks are effectively controlled and limited to levels that do not pose a
serious threat to its capital position. Regulation is an ineffective
substitute for sound risk management at the individual firm level.

Should My Company Use
Derivatives?

Financial derivatives should be considered for inclusion in any
corporation's risk-control arsenal. Derivatives allow for the efficient
transfer of financial risks and can help to ensure that value-enhancing
opportunities will not be ignored. Used properly, derivatives can reduce
risks and increase returns.

Derivatives also have a dark side. It is important that derivatives
players fully understand the complexity of financial derivatives contracts
and the accompanying risks. Users should be certain that the proper
safeguards are built into trading practices and that appropriate
incentives are in place so that corporate traders do not take unnecessary
risks.

The use of financial derivatives should be integrated into an
organization's overall risk-management strategy and be in harmony with its
broader corporate philosophy and objectives. There is no need to fear
financial derivatives when they are used properly and with the firm's
corporate goals as guides.

What Should Regulators Do?

Believing the 10 myths presented here, indeed, believing just one or
two of them, could lead one to advocate legislative and regulatory
measures to restrict the use of derivatives. [9]
Derivatives-related disasters, such as the Orange County bankruptcy and
the collapse of Barings, have led to questions about the ability of
individual derivatives participants to internally manage their trading
operations. In addition, concerns have surfaced about regulators' ability
to detect and control potential derivatives losses.

But regulatory and legislative restrictions on derivatives activities
are not the answer, primarily because simple, standardized rules most
likely would only impair banks' ability to manage risk effectively. A
better answer lies in greater reliance on market forces to control
derivatives-related risk taking, together with more emphasis on government
supervision, as opposed to regulation.

The burden of managing derivatives activities must rest squarely on
trading organizations, not the government. Such an approach will promote
self-regulation and improve organizations' internal controls through the
discipline of market mechanisms. Government guarantees will serve only to
strengthen moral-hazard behavior by derivatives traders.

The best regulations are those that guard against the misuse of
derivatives, as opposed to those that severely restrict, or even ban,
their use. Derivatives-related losses can typically be traced to one or
more of the following causes: an overly speculative investment strategy, a
misunderstanding of how derivatives reallocate risk, an ineffective
internal risk-management audit function, and the absence of systems that
simulate adverse market movements and help develop contingency solutions.
To address those concerns, supervisory reforms should focus on increasing
disclosure of derivatives holdings and the strategies underlying their
use, appropriate capital adequacy standards, and sound risk-management
guidelines.

For the most part, however, policymakers should leave derivatives
alone. Derivatives have become important tools that help organizations
manage risk exposures. The development of derivatives was brought about by
a need to isolate and hedge against specific risks. Derivatives offer a
proven method of breaking risk into component pieces and managing those
components independently. Almost every organization--whether a
corporation, a municipality, or an insured commercial bank--has inherent
in its business and marketplace a unique risk profile that can be better
managed through derivatives trading. The freedom to manage risks
effectively must not be taken away.

Notes

[1]. In May 1994 the General Accounting Office
released a two-year study, "Financial Derivatives: Actions Needed to
Protect the Financial System," GAO/GGD-94-133, which sounded a call for
stiffer government regulation of financial derivatives markets. General
Accounting Office, "Derivatives: Actions Taken or Proposed since May
1994," GAO/GGD/AIOMD-97-8, reviewed progress made by financial regulators
and industry participants.

[4]. See, for example, the recommendations
outlined in Group of Thirty Global Derivatives Study Group, "Derivatives:
Practices and Principles," July 1993. The Group of Thirty is an
international financial policy organization made up of representatives of
central banks, international banks, securities firms, and academia.

[5]. This example was inspired by Gregory P.
Wilson, "BAI/McKinsey Survey on the Usage of Derivative Products," Paper
presented at Bank Administration Institute Conference on Derivative
Products--From A to Z, Chicago, December 6-7, 1993.

[6]. A basis point is a percentage point, or
0.01 percent. The difference between a yield of 5.50 percent and one of
4.00 percent is 150 basis points.